III. The Deep Structure of Professor Weidner’s Critique
A. The Two Key Premises
Two important, related premises appear recurrently in The Unfortunate Role; they support the article’s four most important arguments in various ways. One premise critiques the drafting methodology of the ULLCA (2006) drafters and proffers instead a UPA (1997)–based frame of reference. The proffered frame of reference gives rise to the second premise—the desideratum of giving LLC members “easy access” to judicial remedies (“easy access to judicial remedies” or “easy access”).
According to The Unfortunate Role, the methodological error is fundamental—the ULLCA (2006) drafters lost sight of the act’s appropriate target group. UPA (1997) had identified the group correctly, and ULLCA (1996) followed suit. Then, however, ULLCA (2006) not only abandoned the proper frame of reference but did so without even a word of explanation.
Having in mind that the proper target group leads (almost ipso facto) to the article’s second principal premise, for the purposes of The Unfortunate Role, “easy access” means no direct/derivative distinction. Because the SLC presupposes that distinction, from The Unfortunate Role’s perspective, the SLC is unfortunate (and wrong) from the “git go.”
B. The Unfortunate Role’s Fundamental Objection
Thus, the SLC is actually not The Unfortunate Role’s fundamental concern, despite the article’s engaging title. The article’s most basic complaint is against the direct/derivative distinction itself. It is this distinction that (i) identifies a myriad of claims as belonging to the company rather than to any of its owners; and (ii) thereby precludes easy access to judicial remedies.
The SLC is merely an add-on problem, since an SLC can exist only with regard to a derivative claim. Eliminate the direct/derivative distinction and you eliminate SLCs (along with whatever failings and virtues an SLC may provide).
From this perspective, The Unfortunate Role makes four allied complaints, which might be summarized into four major points, using the expression “and if that weren’t bad enough.” Thus, in the view of The Unfortunate Role, and to the unwarranted prejudice of “easy access”:
- ULLCA (2006/2013) imposes the direct-derivative distinction where the distinction ought not be.
- And, if that weren’t bad enough, ULLCA (2006/2013) exalts the special litigation committee, which is an inherently corporate mechanism and thus alien to the limited liability company.
- And, if that weren’t bad enough, through its statutory text and official comments ULLCA (2006/2013) adopts the Auerbach test rather than the Zapata test. Although, per The Unfortunate Role, the latter is demonstrably better for plaintiffs than the former.
- And, if that weren’t bad enough, ULLCA (2006/2013) does not sufficiently emphasize the importance of SLC members being independent and disinterested and, in some circumstances, even permits the SLC to be appointed by one or more of the derivative defendants.
IV. Critiquing The Unfortunate Role’s Two Fundamental Premises
As noted above, two fundamental premises recur throughout The Unfortunate Role: ULLCA (2006/2013) has deserted its appropriate target group and moreover destroyed a member’s easy access to judicial remedies.
A. In Its “Abandoning the Target Group” Premise, The Unfortunate Role Misapprehends the Evolution of the Uniform Limited Liability Company Acts.
In the view of some academics, when a statute delineates and facilitates business transactions, the statute’s default rules should reflect the assumed desires of one particular subset of expected users: legally unsophisticated members of the population. Professor Weidner subscribes to this view, and in The Unfortunate Role he praises ULLCA (1996) for its “vision that the target group for the 1996 Act was small groups of entrepreneurs operating informally without the benefit of sophisticated counsel.” In this respect, apparently, ULLCA (1996) followed UPA (1997), whose “primary focus . . . is the small, often informal, partnership.”
According to The Unfortunate Role, ULLCA (2006/2013) abandons this focus, deserts the target group, and substantially impairs a key desideratum of the target group—i.e., easy access to judicial remedies. Worse, this repudiation of ULLCA (1996)’s core values took place sub silentio—i.e., with “no indication that the statute’s target group had shifted away from small groups of entrepreneurs operating informally and without the benefit of sophisticated counsel.”
If indeed ULLCA (1996)’s lodestar was “The Target Group of the 1996 Act and Easy Access to Member Remedies,” then ULLCA (2006) did indeed make a change. The drafting committee for the 2006 act focused not on a hypothetical set of users with a hypothetical set of attitudes, but rather on the state of the law across the United States—as benefits a uniform act. The Prefatory Note to make this point up front:
Eighteen years have passed since the IRS issued its gate-opening Revenue Ruling 88-76, declaring that a Wyoming LLC would be taxed as a partnership despite the entity’s corporate-like liability shield. More than eight years have passed since the IRS opened the gate still further with the “check the box” regulations. It is an opportune moment to identify the best elements of the myriad “first generation” LLC statutes and to infuse those elements into a new, “second generation” uniform act.
The drafting committee to ULLCA (2006) had ongoing input from a myriad of advisors from the American Bar Association. The chair of the drafting committee, Dean David Walker of Drake Law School, gave as much credence and air time (if not more) to the advisors as to the ULC commissioners. His goal was consensus. When a vote was to be taken, the initial (and often the only) vote counted commissioners and advisors “per capita.” Dean Walker made separate counts only on the rare occasions, when, after lengthy discussion, consensus seemed impossible. Even in these limited circumstances, the decision made by vote of the commissioners never differed from the opinion expressed by the majority of advisors.
The advisors to the ULLCA (2006) drafting committee included some of the nation's leading practitioners in the field of business enterprises, as well as most of the academics who at the time interested themselves in limited liability companies. Committee meetings often involved detailed discussions contrasting proposed statutory language with the practice “on the ground,” as well as frequent discussions to the effect of “you have to understand how our clients see this and how they understand and operate their businesses.” Discussion with state bar committees pushed the drafting committee’s perspective even deeper into the weeds of actual practice.
So, undoubtably, the ULLCA (2006)’s focus differs from the focus The Unfortunate Role ascribes to ULLCA (1996). However, for matters relevant to this article, The Unfortunate Role misapprehends ULLCA (1996). That is, key parts of ULLCA (1996) bely the article’s “abandonment” and “easy access” assertions.
For starters, the sole relevant statement in the act’s Prefatory Note pertains to “draft[ing] a flexible act with a comprehensive set of default rules designed to substitute as the essence of the bargain for small entrepreneurs and others.” There is no mention of the entrepreneurs being unsophisticated or necessarily bereft of counsel.
Even more problematic for The Unfortunate Role are key statutory provisions of ULLCA (1996). The Unfortunate Role praises Section 410 of ULLCA (1996) for granting “members . . . the same easy access to judicial remedies as partners . . . [including being] able to sue one another, or the firm, for any breach of the operating agreement or the LLC act.” However, nothing in the language of Section 410 addresses, let alone eliminates, the notion of standing. Moreover, the official comment to Section 410 expressly recognizes the direct/derivative distinction and states categorically: “[U]nder this section . . . [a] member pursues only that member’s claim against the company or another member under this section. Article 11 governs a member’s derivative pursuit of a claim on behalf of the company.”
The Unfortunate Role attempts to dismiss Article 11 as merely supplemental—i.e., as an additional tool available to a complaining member at the member’s discretion. Citing no authority or other support, and ignoring the above-quoted comment to ULLCA (1996), Section 410, The Unfortunate Role states that “the 1996 Act . . . provide[s] members the option to bring a derivative action.”
I categorically disagree. The option interpretation renders Article 11 a nullity. Even the strongest advocates of the direct-derivative distinction recognize it as constraining the power of would-be plaintiffs. Opponents, for their part, denigrate “the derivative proceeding [as] involv[ing] burdensome, and often futile, procedural requirements,” and decry “the tribulations of the derivative pathway [which are used] to deter, or at least delay, [a] minority [owner’s] quest for justice.” Why would any sane plaintiff opt in to such tsuris?
Put another way, if the drafters of ULLCA (1996) intended Article 11 to apply solely at the plaintiff ’s discretion, those drafters were wasting their time; they were merely creating “surplusage or a nullity.” Put more formally, to suggest that under ULLCA (1996) derivative claims are optional is to contravene one of the most fundamental rules of statutory construction—“the interpretive canon against surplusage—the idea that ‘every word and every provision is to be given effect [and that n]one should needlessly be given an interpretation that causes it to duplicate another provision or to have no consequence.’”
Thus, if, as The Unfortunate Role asserts, derivative claims and the direct/derivative distinction destroy “easy access,” then The Unfortunate Role must abandon ULLCA (1996) as a basis for decrying ULLCA (2006/2013). Put another way, the section of The Unfortunate Role captioned “The Target Group of the 1996 Act and Easy Access to Member Remedies” is infelicitous, and stating that it was “RULLCA that took away a member’s easy access to … remedies” is straight out wrong.
B. The Unfortunate Role Never Explains Why “Easy Access” Is the Correct Approach for an LLC Statute and Seems Almost to Take the Premise as a Given. The Article’s Limited Efforts to Support the Premise Are Flawed.
1. The Unfortunate Role invokes both ULLCA (1996) and UPA (1997) to support the easy access premise. The Unfortunate Role is just flat out wrong about the former, and the latter is at best a frail reed.
In exalting “easy access,” The Unfortunate Role relies principally using ULLCA (1996) to attack ULLCA (2006). The argument seems to be the following: with ULLCA (1996), the ULC actually got this point right. With ULLCA (2006), the ULC ignored its previous wisdom and messed up.
This argument is unworkable as a matter of both history and logic. “Derivative suits . . . have been recognized for most of two centuries.” And as shown above, contrary to The Unfortunate Role’s understanding, it was ULLCA (1996) that adopted the reprehensible direct-derivative distinction. In addition, stating that a particular statute “got it right” on an important policy issue does nothing to explain why the particular statute’s approach actually was the right decision.
The Unfortunate Role also attempts to justify “easy access” by relying on UPA (1997)’s approach as the standard, faulting ULLCA (2006/2013) accordingly. To explain this latter line of support, The Unfortunate Role quotes an earlier article authored by Professor Weidner, which in turn quotes a UPA (1997) comment:
RUPA (1997) section 405 went “far beyond” the UPA rule and provided that a partner may sue the partnership or another partner at any time, for legal or equitable relief, to enforce the partner’s rights under the partnership agreement or under RUPA (1997). Section 405 “reflects a new policy choice that partners should have broad judicial discretion to fashion appropriate remedies.”
However, although UPA (1997) does not provide for derivative claims, the just quoted language is not really on point to that issue. In the comment, the lead-in sentences to the quoted passage are as follows:
Section 405(b) is the successor to UPA Section 22, but with significant changes. At common law, an accounting was generally not available before dissolution. That was modified by UPA Section 22 which specifies certain circumstances in which an accounting action is available without requiring a partner to dissolve the partnership. Section 405(b) goes far beyond the UPA rule. It provides that, during the term of the partnership, partners may maintain a variety of legal or equitable actions, including an action for an accounting, as well as a final action for an accounting upon dissolution and winding up.
Thus, taking the comment as a whole, UPA (1997)’s key reform in this area is expanding owner access to courts before dissolution, not eschewing the direct/derivative distinction.
As to that distinction, the UPA (1997) comments contain only one sentence: “Since general partners are not passive investors like limited partners, [UPA (1997)] does not authorize derivative actions.” The logic of the asserted connection is not apparent. Shareholders in closely held corporations are typically active in the business, and yet the direct/derivative distinction prevails in that context (and beyond) in the overwhelming majority of jurisdictions. The one sentence comment states a weak rationale (at best) for the UPA (1997) rule, and no basis whatsoever for exporting that rule to limited liability companies, where one of the two basic governance structures is manager-management with non-managing members essentially passive.
2. For The Unfortunate Role, the virtues of “easy access” seem almost a given. In fact, however, those virtues rest on two other assumptions:
- “more is better” as to lawsuits inter se owners in a closely held business; and
- majority owners tend to be oppressive and minority owners are long suffering.
For example, The Unfortunate Role makes much of a law review article, How Do Legal Standards Matter? An Empirical Study of Special Litigation Committees (“Empirical Study”), published formally in 2020. The article concludes inter alia that a rule of law announced in Zapata Corp. v. Maldonado tends to favor plaintiffs in derivative litigation more than a comparable rule announced in Auerbach v. Bennett. From this conclusion, The Unfortunate Role criticizes ULLCA (2006/2013) for following Auerbach rather than Zapata and for thereby derogating “easy access.”
Leaving aside for the moment serious limitations on and caveats to the research, Zapata is the better rule only if we assume that plaintiffs should win. And Empirical Study supports Zapata over Auerbach only upon the same assumption. Academics have debated this point for years, particularly in reference to public corporations, but there is no statistical study available suggesting (let alone concluding) whether:
- in public corporations, strike suits (and the harm they cause) outnumber and outweigh legitimate derivative claims (and the value they provide), or vice versa; or
- in closely held businesses, plaintiffs claiming oppression are more often justified than unreasonably disgruntled, or vice versa.
In my experience, some plaintiffs should win, and others definitely should not.
3. The Unfortunate Role ignores a major, pro-plaintiff rule instituted by ULLCA (2006), in contradistinction from both ULLCA (1996) and UPA (1997).
UPA (1997) “cabined-in” fiduciary duty, and ULLCA (1996) dutifully followed suit. That is, both statutes purported to provide an exhaustive list of fiduciary duties, and the list excluded any duties owed by one owner (partner/member) to another owner. The exclusion is highly ironic for present purposes; recognizing owner-to-owner fiduciary duties was seminal as the law developed protections for minority owners in closely held corporations and, more recently, in closely held LLCs.
The drafting committee to ULLCA (2006) saw cabining-in as imprudently restrictive on a member’s legitimate claims of member-to-member abuse. As explained in the Prefatory Note:
RUPA . . . pioneered the idea of codifying partners’ fiduciary duties in order to protect the partnership agreement from judicial second-guessing. This approach—to “cabin in” (or corral) fiduciary duty—was followed in ULLCA and ULPA (2001). In contrast, the new Act recognizes that, at least in the realm of limited liability companies:
- the “cabin in” approach creates more problems than it solves (e.g., by putting inordinate pressure on the concept of “good faith and fair dealing” [and thereby constraining member-to-member claims of misconduct]); and
- . . . better way[s] [exist] to protect the operating agreement from judicial second-guessing . . . . Accordingly, the [ULLCA (2006)] codifies major fiduciary duties but does not purport to do so exhaustively.
4. Despite repeatedly invoking the “easy access” mantra, The Unfortunate Role pays scant attention to ULLCA (2006/2013)’s primary recourse for LLC members claiming mistreatment—i.e., the oppression remedy.
The article does include a section captioned “RULLCA’s Offsetting Cause of Action for Oppression,” but the section is inaccurately dismissive and comprises only 313 words (exclusive of footnotes). The section begins with the following premise, which is inaccurate in two ways: “RULLCA gave LLCs additional corporate features to take advantage of liberalized tax classification rules [the check the box regulations] and facilitate lower estate tax valuations.”
The first part of the premise—the addition of “corporate features” after check-the-box—omits crucial context. ULLCA (2006) was no innovator here. The check-the-box regulations produced an avalanche of legislative changes across every jurisdiction in the country. Long before the ULLCA (2006) committee began its work, LLC statutes across the country:
- eliminated or greatly attenuated the connection between the dissociation as an LLC member and the dissolution of the LLC;
- established perpetual duration as the norm; and
- provided for single member LLCs.
Taking any other approach would have ignored the ULC’s central mission—“to promote uniformity in the law among the several States on subjects as to which uniformity is desirable and practicable”—and would have precluded widespread, uniform enactment.
The second part of the premise—that “corporate features” were added to “facilitate lower estate tax valuations”—is simply wrong. Nowhere in its statutory text or official comments does ULLCA (2006) refer even implicitly to estate valuations. The ULC has in fact designed a uniform act to facilitate estate planning, but that act is not ULLCA (2006). That act is ULPA (2001):
The [2001 Uniform Limited Partnership] Act has been drafted for a world in which limited liability partnerships and limited liability companies can meet many of the needs formerly met by limited partnerships. This Act therefore targets two types of enterprises that seem largely beyond the scope of LLPs and LLCs: (i) sophisticated, manager-entrenched commercial deals whose participants commit for the long term, and (ii) estate planning arrangements (family limited partnerships).
Beyond its flawed premise, the “Offsetting Cause of Action” section says very little. The section does note that ULLCA (2006) “leaves it to the courts to decide when [the oppression remedy] will be available.” but does not consider in any depth how the oppression remedy is functioning in the context of limited liability companies.
This omission is very significant. In the related realm of closely held corporations, the oppression remedy has become the principal litigation recourse for minority shareholders, and LLC case law is following suit. “As with corporations, the overwhelming majority of limited liability companies are closely held. As a result, disputes about power abuses within closely-held businesses increasingly occur in the context of LLCs rather than corporations; and the terms ‘oppression’ and ‘reasonable expectations’ increasingly appear in cases involving limited liability companies.”
5. The Unfortunate Role pays no attention to the overarching practical threats inherent in installing a pro-litigation stance into a business entity statute—especially for an entity used most often to house a closely held business.
The threat is well known by litigators and transactional lawyers alike: litigation among members of a closely held business is distracting, expensive, and—depending on the finances of the business—potentially ruinous for all concerned.
In addition to auguring expense, “easy access” undermines business continuity, although Professor Weidner would apparently disagree. The Unfortunate Role praises “the policy choice that was made in UPA (1997) and in the 1966 Act, which was that modern business acts result in business entities that are legally and contractually stable enough to withstand internal litigation.” This author’s experience is entirely contrary. Most often, a claim of oppression invokes a statute providing for not continuity but rather for dissolution, with a buy-out of the plaintiff as a less drastic alternative. Internecine warfare rarely, if ever, results in renewed harmony.
Of course, disharmony is a justified product of actual oppression. The question is whether to tip the scales categorically to plaintiffs in the name of easy access.
V. Controverting The Unfortunate Role’s Four Principal Arguments
A. The Direct-Derivative Distinction
According to The Unfortunate Role, “RULLCA’s implementation of the derivative model is . . . outdated and flawed,” and, in its attack of the direct-derivative distinction, The Unfortunate Role asserts at least six different flaws. ULLCA (2006/2013)’s direct/derivative distinction:
- creates, without justification, a major barrier to member access to judicial remedies;
- precludes parties to a contract from having automatic standing to sue for breach of the contract;
- is inherently corporate and therefore does not belong in the realm of limited liability companies which—like partnerships—are unincorporated;
- occasions excess litigation;
- is not justified theoretically by the LLC being a legal person distinct from its owners; and
- reverses ULLCA (1996)’s wise decision to eschew the direct-derivative distinction.
The rest of this Part V.A addresses these points in turn.
1. Easy Access
This part of The Unfortunate Role’s critique of the direct-derivative distinction is simply the assertion of one of the article’s two overarching premises—i.e., the overarching importance of members having easy access to judicial remedies. Accordingly, Part IV.B.2, which identifies multiple defects with the easy access premise, is “incorporated here by reference.” In addition, as noted in Part IV.B.5, eschewing the direct-derivative distinction in the name of easy access results in numerous, fact-specific practical problems. The following examples illustrate some of these problems:
Example 1: One, LLC is a five-member limited liability company, with one member serving as manager. One of the other four members believes vehemently that the manager is taking the LLC “in the wrong direction,” while the manager (of course) and the other three members support the manager’s decisions. Under The Unfortunate Role’s “easy access” approach, the one dissatisfied member could allege breach of the duty of care and force the LLC into potentially expensive and protracted litigation. Absent the direct-derivative distinction, the dissatisfied member would have this power regardless of how small the member’s interest might be.
Example 2: Two, LLC is a member-managed limited liability company with three members, with no express operating agreement. The three members are in agreement that D. Merit (“Merit), one of Two’s employees, has brought Two into ill repute through unethical and possibly illegal sales tactics. Two members want to terminate Merit’s employment, “move on,” and avoid negative publicity as much as possible. However, the third member, A. Gressive (“Gressive”) wants also to sue Merit. Without the direct-derivative distinction, Gressive might well have the right to sue Merit directly.
Example 3: Three, LLC is a two-member, manager-managed limited liability company. Alpha contributes 90 percent of the start-up capital and is the manager. Beta contributes 10 percent. To the greatest extent allowed by the law of Three’s jurisdiction of formation, the operating agreement:
- grants Alpha full discretion in running the company; and
- exonerates and indemnifies Alpha for Alpha’s conduct as manager except to the extent that Alpha does not act “in good faith.”
Three has a fifteen-year term of existence, and neither Alpha nor Beta has any right to exit the company. However, Beta becomes disenchanted with Beta’s investment in Three and seeks a way to force Alpha to buy Beta out (either directly or through the company). Alpha has done nothing to cause Beta any direct injury. However, due to a major drafting error, the operating agreement does not define “good faith,” which gives Beta an opening to claim some misconduct by Alpha.
Without the direct-derivative distinction (under the “easy access” approach), Beta can become a significant nuisance, at minimum forcing Alpha to litigate at least through summary judgment. Depending on the value of Beta’s interest, “easy access” may give Beta substantial bargaining power.
As acknowledged in Part IV.B.5, the direct-derivative distinction does not eliminate disharmony. Indeed, as the above Examples illustrate, the direct-derivative distinction (i) matters precisely when disharmony exists; and (ii) in those circumstances prevents a disgruntled member from weaponizing a claim that, even if valid, offers the member no recovery. In some circumstances, the distinction prevents a disgruntled member from using an alleged injury to a fellow member to promote the disgruntled member’s own, differing agenda (“intermeddling”). In other circumstances, the distinction prevents a disgruntled member from arrogating to itself the ability to delineate the best interests of the company (“arrogation”).
2. Precluding Contract Parties from Suing for Breach
The Unfortunate Role takes great issue with how the direct-derivative distinction channels claims for breach of the operating agreement. The direct harm requirement of ULLCA (2006/2013) Section 801 makes no exception for such claims. An official comment distinguishes the operating agreement from an ordinary commercial contract for which “it is axiomatic that each party to [the] contract has standing to sue for breach of that contract.” Further, the comment asserts that the direct harm requirement protects the operating agreement.
The Unfortunate Role criticizes the official comment for not stating how or why an operating agreement differs from an ordinary commercial contract for standing purposes. Further, the article asserts that, “[i]t is unclear how an agreement is ‘protected’ by raising procedural barriers to its enforcement.”
The official comment’s rationale is at best implicit, and The Unfortunate Role could fairly argue that the two points quoted above are merely bald conclusions. However, the comment’s deficiency does not impair the rule, which rests on both (i) significant practical concerns; and (ii) the conceptual distinction between an ordinary commercial contract and what the Delaware Supreme Court has termed “the constitutive contract” of an unincorporated business organization.
The Examples above illustrate the mischief that can arise if, given a claim for breach of the operating agreement, party status replaces the direct harm requirement. On the conceptual point, the Delaware Supreme Court has stated categorically that “the source of the duty owed—the entity’s constitutive agreement [e.g., a limited partnership agreement, an operating agreement]—does not alone answer the question as to whether [a] . . . claim [is] derivative, direct, or both.”
That statement appears in El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, a case involving alleged breaches of limited partnership agreements. In determining claims to be direct, the Court of Chancery had relied on NAF Holdings, LLC v. Li & Fung (Trading) Ltd. in which the Delaware Supreme Court held that an contract promisee’s claim for breach of contract was direct, even though the promisee’s harm derived from harm to a third-party beneficiary. The Chancery Court has seen NAF Holdings as limiting the scope of Tooley v. Donaldson, Lufkin & Jenrette, Inc., Delaware’s seminal case announcing the “direct harm” rule.
In reversing the Chancery Court, the Delaware Supreme Court rejected the Chancery Court’s reliance on NAF Holdings and explained:
NAF Holdings does not support the proposition that any claim sounding in contract is direct by default, irrespective of Tooley. Nor does it mean that [a person]’s status as a limited partner and party to the LPA enable him to litigate directly every claim arising from the LPA. Such a rule would essentially abrogate Tooley with respect to alternative entities merely because they are creatures of contract. Limited partnerships are governed by their partnership agreements and by the Delaware Revised Uniform Limited Partnership Act (the “DRULPA”). The partnership agreement sets forth the rights and duties owed by the partners. The trial court treated the governing instrument of the Partnership as if it were a separate commercial contract, rather than it being the constitutive contract of the Partnership under the DRULPA itself. The reality that limited partnership agreements often govern the territory that in corporate law is covered by equitable principles of fiduciary duties does not make all provisions of a limited partnership agreement enforceable by a direct claim.
The Delaware Supreme Court decided El Paso in 2016—ten years after the promulgation of ULLCA (2006) and fifteen years after the ULPA (2001) originated the “axiomatic” statement. Had this sequence occurred in reverse, the ULC’s official comment would likely have invoked El Paso.
3. Inherently Corporate
The ULLCA (2006) drafting process featured recurrent debates about “corpufuscation,” a word coined to “reflect the disdain expressed by some leading partnership law practitioners for what they see as the creeping corporatization of the limited liability company.” To such practitioners:
the limited liability company is essentially and fundamentally an unincorporated organization, i.e., like a partnership and therefore not like a corporation. [Such practitioners] “view the LLC entity mostly as a necessary evil for maintaining the liability shield,” and perhaps also for obtaining perpetual duration. Adding other “corporate like” characteristics smacks of heresy or at least of “conceptual miscegenation.”
The Unfortunate Role frequently raises concerns that fit the corpufuscation label, especially with regard to the “easy access” issue and the direct-derivative distinction. For example, in one of its numerous laments that LLC law has become increasingly corporate, the article states: “Nowhere has the shift to the corporate model been more dramatic, or more unfortunate, than in access to judicial remedies.” The principal villain in this unfortunate drama is the direct-derivative distinction. Worse, the direct-derivative distinction is not merely corporate in nature but rather uber corporate. That is: the derivative action is a “creature of public corporation law with roots that can be traced back to the nineteenth century.”
Unfortunately for The Unfortunate Role, history does not support this argument. For one thing, the assertion ignores the fact that the direct-derivative distinction has been part of the law of uniform limited partnerships since 1976. In the New York limited partnership statute, the distinction dates back to 1968.
As to the corporate realm, the rise of public corporations may have influenced derivative claim jurisprudence after the 1930s, but the direct-derivative distinction entered U.S. corporate law through an 1832 decision. The case involved a joint stock company and (ironically for present purposes) the decision characterized such corporations as “mere partnerships, except in form.”
Even when the public corporation began to dominate the U.S. economy, derivative claims were at least as likely outside the public corporation world as within it. For example:
A 1944 study of shareholder derivative litigation commissioned by business leaders in New York . . . examined 1,266 lawsuits filed by shareholders in two New York counties and one federal district court in New York from 1932 to 1942 . . . [and found that] . . . 693 of the cases involved closely held corporations.
The Unfortunate Role’s corpufuscation argument fares even worse if one takes into account the law of closely held corporations. That law routinely recognizes the direct-derivative distinction. Given the origins of close corporation doctrine, this recognition augurs poorly for the corpufuscation label. In the words of Donahue v. Rodd Electrotype Co.: “[T]he close corporation bears striking resemblance to a partnership. Commentators and courts have noted that the close corporation is often little more than an ‘incorporated’ or ‘chartered’ partnership.”
Put another way: “The stockholders [in a closely held corporation] clothe their partnership with the benefits peculiar to a corporation, limited liability, perpetuity and the like.” Or, as stated by Warren Burger, before he became Chief Justice of the United States: “[S]tockholders of a close corporation occupy a position similar to that of joint adventurers and partners . . . . Indeed, ‘chartered partnership’ or ‘incorporated partnership’ is a more descriptive and accurate designation of the relationship than ‘close corporation.’”
In sum, to criticize the direct-derivative distinction as excessively corporate is to be exceedingly wrong.
4. Excessive Litigation
According to The Unfortunate Role, “[O]ne of the most frequently litigated areas of LLC law is whether a member’s claim is direct as opposed to derivative.” The article cites no authority for this bald proposition and gives no attention to whether litigation over the direct-derivative distinction may reflect the distinction functioning properly—i.e., to limit direct claims to situations in which the plaintiff member seeks a recovery that directly benefits the member.
The Unfortunate Role tries to use Florida jurisprudence as at least one example of the “excessive litigation” problem. The article directs the reader to Dissatisfied Members in Florida LLCs: Remedies (“Dissatisfied Members”), an earlier article by Professor Weidner, in which he describes the tribulations of making the distinction under Florida law. Dissatisfied Members does indeed recount complexity and identifies Dinuro Investments, LLC v. Camacho as Florida’s leading case. Dinuro in turns states that “[w]hether a particular action may be brought as a direct suit or must be maintained as a derivative suit can be a confusing inquiry.”
However, Dinuro itself clarified Florida law, as the opinion “reconcile[s] nearly fifty years of apparently divergent case law.” The case’s key holding has been cited twenty-seven times. Thus, The Unfortunate Role’s sole example works against the article, even without taking into account the likely clarifying impact of ULLCA (2006/2013)’s bright-line rule.
5. The Connection of the Direct-Derivative Distinction to Entity Status
The Unfortunate Role asserts that a business organization’s status as an entity separate from its owners is irrelevant to the existence vel non of the direct-derivative distinction: “[T]he important question is what characteristics a particular entity should have as a matter of pragmatic policy, not what is logically compelled by abstract notion that the business is an entity.” Moreover, according to The Unfortunate Role “UPA (1997) [has] by statute declared partnerships as entities distinct from their partners,” and UPA (1997) eschews the direct-derivative distinction.
As The Unfortunate Role acknowledges, ULLCA itself does not assert the conceptual connection between entity status and the direct-derivative distinction. The Unfortunate Role correctly assigns that error to the author of this response:
The Official Comment declares that “a limited liability company is emphatically an entity, and the members lack the power to alter that characteristic.” RULLCA Co-Reporter Daniel Kleinberger separately stated his belief that “the distinction between direct and derivative claims follows necessarily from the concept of a legal person being separate and distinct from its owners.”
It might be tempting to moot this dispute by quoting William Shakespeare’s Juliet (“What’s in a name?”) or Lewis Carroll’s Humpty Dumpty (“Which is to the master—[us or the words]?”). However, having recently spent five years studying, debating, and delineating the concept of separate legal personhood, I prefer to address this issue on the merits.
I begin with words from Justice Felix Frankfurter: “All our work . . . is a matter of semantics, because words are the tools with which we work, the material of which laws are made . . . . Everything depends on our understanding of them.” To reach a proper understanding of the connection between entity status and the direct-derivative distinction requires (i) placing the direct-derivative distinction within a broader contextual context; and (ii) controverting The Unfortunate Role’s use of UPA (1997) as evidence that entity status and the direct-derivative distinction are not connected.
As to the broader context, the direct-derivative distinction is not the only legal construct resulting from a limited liability company’s existence as an entity separate from its members. To the contrary, there are myriad consequences:
[A limited liability company’s] separate legal status has numerous consequences. It “allows [LLCs] to shield their members from personal liability,” can render irrelevant a person's misrepresentation of the identity of an LLC's members, and can serve as a vehicle for economic integration, and thereby avoid the “combination in restraint of trade” strictures of the Sherman Antitrust Act. The entity characteristic “prevents an LLC from binding its members or subjecting them to liability or obligations through contracts between the LLC and third parties,” precludes an LLC and its members from filing a joint petition in bankruptcy, and means that a payment made personally to an LLC member does not discharge the payor's obligation to the LLC unless the member had the power to bind the LLC.
The entity characteristic also means that even a one-member LLC must collect and pay sales taxes on retail sales, that payments made by a single-member LLC to the [Internal Revenue] Service on behalf of the LLC's sole member are recoverable by the estate of the LLC in a bankruptcy proceeding, and that a taxing authority may not aggregate the value of personal property owned by several LLCs even though each LLC was owned by the same individual. Likewise, “[f]or the purposes of unjust enrichment, the owners of a limited liability company do not receive a benefit when a third party pledges collateral to secure a debt. incurred by the company. In such cases, the benefit flows to the limited liability company itself, not to the owners of the company.”
The above quoted examples are not exhaustive. The same source identifies numerous areas of law in which separate entity status produces specific legal consequences.
With regard to UPA (1997)’s “separate entity” declaration, “[s]aying so don't make it so.” UPA (1997) retains several constructs that are classic aggregate characteristics and, as such, are antithetical to separate entity status.
The United States Treasury's once famous “Kintner Regulations” provide a good frame of reference to discussing this point. From 1960 through 1997, the Kintner Regulations “enshrined the aggregate aspects of partnership law as part of the regulatory method for determining whether unincorporated business organizations were to be taxed as partnerships or corporations.” The regulations identified four classic characteristics of a corporation—limited liability, continuity of life, free transferability of ownership interests, and centralized management—and classified an organization as a partnership if the organization lacked two or more of the corporate characteristics. A general partnership under UPA (1914) lacked all four corporate characteristics, and in each instance the relevant UPA (1914) provision reflected the lack of separation between a partnership and its partners.
The following chart lists Kintner’s four factors and applies them to both UPA (1914) and UPA (1997). For each factor, the chart: (i) identifies the corporate characteristic; (ii) identifies the opposite, partnership law characteristics as posited by Kintner; (iii) cites the UPA (1914) provision that served as the model for the Kintner Regulations; and (iv) states whether the characteristic persists in UPA (1997).